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As we have discussed, being able to live off of your savings is one of the most important financial goals people should strive for. However, before you can save enough money to truly consider yourself wealthy, you must first address your tax situation.
One area that many people don’t pay attention to until later is how they are taxed when they make a large income. There are several different types of taxes, but unfortunately, not everyone understands what each type is or what loopholes apply to which ones.
In this article, I will go into more detail about how some of the less popular types of taxation work and what strategies you can use to avoid them if applicable. Before we dive in, let us look at how much wealth someone has who spends their life living under the surface of the water.
In short term, or what’s known as ‘ordinary income’ taxes are due when you sell your investment. If it is a small stock, then usually only the selling fees are taxed. But if it is something more expensive like a house or car, then both the sale proceeds and the ordinary income tax must be paid.
In long term, or what’s called ‘capital gain’ taxes are owed only on the increase in value that happens when you sell an asset. There is no obligation to pay any additional money because you sold the item!
This article will go into greater detail about how investing works and some strategies for maximizing your passive income. Included will be information about K1 visa investors, who may or may not be eligible depending on your country of residence and whether or not they qualify as residents of Canada.
A capital loss is when you sell an asset for less than what you paid for it. Most people are not aware that all income includes a deduction of how much your capital loss was! This means if you have to write off a large expense, like buying a house, part of this cost can be deducted from yearly income.
You cannot deduct both business income and capital gains in year-to-year comparisons due to tax laws. However, when looking at long term investment returns, capital gain or loss will matter more slightly.
For example, let’s say you buy a stock for $100 per share. It goes up to $1000 per share so you make a small profit on it. Your taxable income would include the price of the stock ($1000) but also the decrease in value (capital loss).
This is different from when you lose money on a stock. In that case, your taxable income only includes the price you spent on the stock ($1000), not the increase in value. You wouldn’t get a tax break because you lost money.
Many people feel very stressed out about investing. Because they perceive there to be no savings, they give up and don’t invest. This hurts our economy and our future generations.
It is important to understand basic investments such as dividend paying stocks, index funds, and Treasury bills. These are ways to spend wisely and still reap big benefits.
The cost basis of your home is what you can claim as a tax deduction when it comes to paying income taxes. This varies slightly depending on whether your house was paid for in cash or with debt, but generally speaking, the lower your CB, the better.
A higher CB means you’ll be able to deduct more from revenue when it comes time to pay your taxes, making it a good investment. Conversely, if your CB is low then you won’t get this benefit!
The IRS sets a pretty generous floor for the cost basis of an average-priced house (that is, one that costs around $300,000), which is usually the value used when calculating how much you can write off as a capital gain. This amount is referred to as the ‘cap’ baseline.
That said, most people will want to set their cap baseline at least twice the price of their house, just to ensure they’re not overpaying too much in terms of deductions.
Another popular way to reduce your taxable income is by running a business through what’s known as a “passive activity.” A passive activity is a business type or investment structure that you run without actively doing anything with it.
A person can contribute up to $5,000 per year to a retirement account like a 401(k) fund from their employment due to this tax incentive. But investing in stocks or other ventures is not limited to just those under $500,000.
If you make over $50,000 per year then you are allowed to invest an additional $2,500 per year into more speculative investments. These types of investments are not intended to produce large returns, but rather earn small amounts each year while paying little in taxes.
The money earned during these times is credited to either personal or qualified dividends which lower your overall tax burden. More than half of all Americans enjoy such benefits because they invested in dividend producing stocks when young.
There are two main types of business structures used to limit your personal risk in business ventures- limited liability corporations (LLCs) and partnerships.
A LLC is typically formed through an intermediary service that allows you to set up a company with a pre-determined level of liability. This removes you as an individual shareholder from responsibility for debts and liabilities incurred by the business.
Businesses can also have multiple shareholders, which means each owner’s share entitles them to their proportionate amount of credit. For example, if investor X puts up $10,000 then they get 10% equity in the company.
The other part of the income is distributed among all the investors according to their contribution – so if Investor Y put in twice as much as X, they would get half as much return!
This is different than a partnership where each partner gets equal shares. In a partnership, even though one person may make more money or less depending on how hard they work, everyone’s earnings are divided equally. It is very common for people to earn more as individuals outside of a partnership, however.
Forming an LLC comes with its own suite of legal fees, but this structure can reduce your personal tax burden. You will need to know what kind of income you receive form the business and report it correctly on your taxes, but otherwise you cannot be held liable.
You can read more about the differences between LLCs and partnerships here.
Almost every business has two forms, an individual or “person” form and a corporation (or LLC) form. An individual is called the owner/founder of the business while the corporation acts as a legal entity to structure the business and pay its bills.
Typically, the owner transfers their share ownership in the company to the corporation in exchange for it paying all of its expenses and giving them some income. This income can be distributed directly to the owners or used by the firm for additional services.
The easiest way to avoid taxation with this type of business is to have the shareholder(s) be individuals instead of the corporation. By having individuals own the shares, they are personally liable for any debts incurred by the business and paid off by the shareholders themselves.
This may not sound ideal, but it makes sense when you think about it. If someone else is taking responsibility for the debt then they must want to keep the business going! Most people agree that running your own business is more profitable than being employed at another company, so most people would rather stay in control.
Another option is starting your business through a limited liability business such as a partnership or sole proprietorship instead of using a corporation. Both of these types of businesses limit how much money each person involved in the business is legally held accountable for, making it less likely that anyone will try to take over the company.
The way you calculate taxable income is by looking at how much money you have after expenses, and then adding in any other revenue sources like interest, capital gains, etc. Then, depending on where you live, how much of your income gets taxed differently.
Certain types of income are taxed more heavily than others. For example, ordinary income is usually taxed somewhere between 20% and 40%, while long-term capital gain can be as high as 15%.
These types of incomes are called higher-income brackets. As we mentioned before, when you exceed the threshold for these higher-taxed categories, you pay more in taxes per each additional dollar earned.
That’s why it is important to understand what kind of income you make and how much tax you owe. There are many online tools that can help you do this, but nothing replaces knowing the rules inside and out yourself.
This article will go into greater detail about some of the passive income concepts that most people don’t know about when it comes to taxation.
As discussed, being able to clearly identify your passive income is the first step in determining how much tax you owe. Now that we’ve covered some of the common types of passive incomes, let's take a look at some examples!
Say you earn $5,000 per month from online selling and you estimated your net profit for the year was $20,000. Your monthly income would be calculated as follows:
$5,000 x 12 = $60, 000 _________ Net Profit
Now, using our Example Paragraph above, say you choose to report both your online sales and rental profits as active earnings. This means they are considered non-passive income due to the requirement to have employees involved in their production or maintenance.
If this were so, then your total annual income would include not only your online business revenue, but also your rental income which produces additional taxable income. In this case, your yearly gross income would be:
$5,000 + $20,000 = $25,000 ____________________ Gross Annual Income
Then, using average state personal income tax rates, find out what your marginal rate (what percentage of income goes towards paying taxes) is by multiplying your gross income by your marginal rate and dividing it by 100. For example, if your marginal rate is 10% then divide your gross income by 1.01 (=10%) to get your marginal income level.
